Subbarao’s RBI Report Card

Duvvuri Subbarao at the headquarters of the Reserve Bank of India, Mumbai, July 31.

India’s out-going Reserve Bank of India Gov. Duvvuri Subbarao earned plaudits for keeping inflation in check and asserting the central bank’s independence from the government. But the sharp slide in the value of the rupee on his watch could cast a shadow on his legacy.

Mr. Subbarao has had a tough five years at the helm of the central bank. He joined a few weeks before the collapse of U.S. investment bank Lehman Brothers Holdings Inc., which caused a meltdown in global markets and signaled the start of a deep global recession.

As governor, he had to deal with high domestic inflation, a worsening trade balance, slowing growth and political interference, all against the backdrop of a volatile global economy.

But the currency, which has lost more than 30% of its value against the U.S. dollar during his term, has emerged as his main bugbear.

“The main cause of the rupee’s weakness is the high current account deficit and the RBI governor is not responsible for that,” said Rupa Rege-Nitsure, chief economist at the Bank of Baroda.

Still, the RBI’s recent steps to arrest the rupee’s fall have drawn criticism. In July, the RBI started tightening the supply of cash to the local banking system to make the rupee more expensive. As a result, short-term interest rates spiked and banks pushed up lending and deposit rates.

Last week, the RBI also reduced the amount of money that Indian companies and residents can send overseas. Local stocks and the rupee were sold off heavily because investors feared this was a precursor to stopping foreigners taking money out of the country.

The finance ministry said it has no intention of imposing capital controls on foreigners, which can become a trap if there is a full-blown crisis and foreigners can’t cut their losses and exit India.

Then, in a shift on Tuesday evening, the RBI relaxed its liquidity tightening measures, saying it was important to ensure that “liquidity tightening doesn’t adversely impact the flow of credit to the productive sectors of the economy.”

Analysts saw this as a potentially credibility-damaging reversal by the RBI.

Under Mr. Subbarao, the RBI was one of the world’s most hawkish central banks, raising rates by 3.75 percentage points between March 2010 and October 2011 to fight inflation.

Wholesale inflation dipped below 5.0% in April this year for the first time in 40 months, signaling a success for the RBI. However, some analysts say the central bank went too far in raising rates, which contributed to the sharp slowdown in India’s economy.

“He has been behind the curve in his monetary policy. There was data [in late 2011] showing that industrial production was slowing but he continued to raise rates,” said Ashima Goyal, an economist and member of an external panel that advises the RBI on monetary policy.

A related criticism of the RBI is it tried to curb demand for goods to cool prices, even though inflation was being driven by inadequate supply of goods due to a lack of investment.

The RBI said monetary policy has a role even if inflation is driven by supply-side factors. This is because sustained high inflation creates the expectation among consumers that prices will keep rising. This leads workers to demand higher wages and companies to increase prices of their products. Monetary policy has to contain these inflation expectations, the RBI says.

The RBI also faced intense pressure to ease its monetary policy last year, with the finance minister publicly calling for lower rates. But Mr. Subbarao refused, and instead put pressure on the government to reduce its fiscal deficit, which it said was a source of inflation.

“He did very well to refuse the pressure of lowering interest rates at the time when government deficits were mounting last year,” said Viral Acharya, a professor at New York University’s Stern School of Business.

Mr. Subbarao also increased communication with markets. Under him, the RBI started publishing a weekly schedule of the governor’s and deputy governors’ public speaking engagements on its website. It said this was “aimed at demystifying the offices” of the governor and deputy governors.

Mr. Subbarao also introduced a “guidance” section in his monetary policy statements to provide investors with more visibility on monetary policy plans.

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